Capital Adequacy Requirements, Bank Behavior Research And Regulatory Effects

From the perspective of internal capital allocation mechanism of banks, this paper analyzes the impact on the bank behavior of the capital requirement based on 1988 Basel Accord, and the induced regulatory effects by the adjustment of bank behavior. The capital allocation mechanism of banks is found to be an important channel, through which the external capital regulation affects bank behavior. Then, based on the theoretical analysis, empirical research is carried on to test the regulatory effects of Regulation Governing Capital Adequacy of Commercial Banks, the capital adequacy requirement rules in China, published in March 2004. Partial adjustment framework and simultaneous equation method are used to test the impact on the capital level and the risk level of the bank's portfolio.The impact of capital regulation on the capital allocation behavior of traditional banks is analyzed first. On the shock of the regulatory capital requirement, the traditional banks will implement the capital allocation according to the regulatory model. Thus, banks are forced to adopt the risk-adjusted capital allocation to their business lines and products, and then measure the performance of the business lines and products according to the capital allocated, further, adjust the asset portfolio based on the performance of the assets. Thus, the 1988 Basel-like capital regulation framework causes banks to shift their portfolio from the asset with the higher risk weight to the ones with lower risk weight. This explains the portfolio shift behavior of banks and the credit crunch effect of capital regulation can be explained. Also, the shift between assets with the same risk weight is analyzed, for example, corporate loans have the same regulatory risk weight, but loan with lower risk has lower expected returns than the one with higher risk, then the returns on the capital allocated differ, this will cause the bank to give up some low risk business lines faced too high regulatory capital requirements, unless some method can be found to lower the effective regulatory capital requirements for these business lines.Well, regulatory capital arbitrage provides the right solution. Banks will pursue the minimization of the effective regulatory requirement faced by each business line. Regulatory capital arbitrage can achieve this goal. Acting as the safe valve of external regulatory capital requirements, regulatory capital arbitrage can effectively alleviate the unnecessary high capital requirements. Thus, with regulatory capital arbitrage,banks could still carry on the low risk business lines, which will be given up otherwise. And in this way, the distorted effect on the asset allocation of capital regulation is corrected.Based on the theoretical analysis, empirical research is carried on to test the regulatory effects of Regulation Governing Capital Adequacy of Commercial Banks. Capital regulation is found to be effective in elevating the capital adequacy ratio of the under-capitalized banks. Also, a negative association between changes in risk level and capital adequacy level is found. This is not surprising because banks will respond to the risk-based standard by reconfiguring their portfolio toward lower risk-weighted asset. Further, banks with lower capital ratio are found to have lower loan growth rate than the ones with higher capital ratio, shows that capital regulation has more significant impact on the loan growth of the under-capitalized banks.Based on the theoretical and empirical research, this paper gives some suggestions on the improvement of the capital regulation institution in China and also on the direction of further research.